Friday, October 30, 2015

Would it make sense for Apple to peg its stock price at $1? If so, how would it go about doing this?

From the perspective of shareholders, there's an advantage to a firm's shares being valued not only as a pure store of value but also as useful in trade, or as money. All things staying the same, the increase in demand that is created by the monetary usefulness of a share will ratchet up the multiple applied to a firm's earnings, resulting in a higher market capitalization and richer (and happier) shareholders. As long as the costs of making shares more moneylike aren't too high (I'll assume they aren't), Apple will prefer that its shares be ubiquitous and pervade all corners of an economy, much like a U.S. dollar note or a bank deposit.

The problem is that people aren't fond of unstable exchange media (see here & here). Bills and deposits tend to show low price variability. And because retailers keep prices sticky in terms of the unit of account, a $100 deposit or $100 bill is guaranteed to purchase $100 worth of stuff one month hence. Unlike bills and deposits, volatile assets like Apple shares can crater at any moment, thus ruining their effectiveness as a monetary medium.

Could Apple solve this problem? If Apple were to peg its stock price at $1, it would provide individuals with all the benefits of a dollar bill or deposit. Add in some infrastructure for allowing payment via stock (say a permissioned block chain), and demand for Apple shares would treble as they stole business from banks. Apple's market cap would spike.

What about investors, say hedge funds and mutual funds? Why would they want to own an asset that never deviates from $1? They need a return, after all, to justify holding Apple in their portfolio. The answer, in short, is that the peg wouldn't reduce Apple's return to zero; rather, it would change the form of the return. Instead of rewarding shareholders with a higher share price, Apple management would reward them by augmenting the quantity of stable-value shares they own.

Say Apple's earnings are to grow 10% over the course of a year. Without a peg, investors expect one share of Apple, currently trading at $1, to be worth $1.10 in one year, providing a 10% return. With a peg, investors will instead expect the quantity of $1 shares in their portfolio to grow from 1 to 1.1, thus providing the same 10% return. Think of the 0.1 increase in shares as a stock dividend to all existing shareholders.

If Apple has a blowout year and earnings grow 20% rather than just 10%, investor demand for Apple shares will rise, putting upwards pressure on the peg. Management will grant existing owners whatever extra stock dividends are necessary to relieve the pressure. Likewise, a rise in the monetary demand for Apple shares, perhaps due to a liquidity crisis, will by counterbalanced by a stepped up pace of stock dividends, ensuring the peg's integrity.

Conversely, downwards pressure on the peg will be relieved with a series of reverse stock dividends. Shareholders will find that, where before they had $1 share worth $1, they have been docked 0.01 shares and only have 0.99 shares worth $1 dollar.

For the public to accept Apple's pegged shares as an exchange medium, they need to suffer from some sort of money illusion. After all, even though Apple is enforcing its $1 peg and providing nominal stability, this is little more than an illusion. The reverse stock dividend mechanism threatens to reduce the quantity of shares in each individual's portfolios, thus diminishing their overall purchasing power. Will people be fooled by the $1 price? I don't know, but if so, Apple can increase its market capitalization for free and thus enrich its shareholders.

This leads into a bigger question that I'll let others try and answer. What quirks of human psyche (or institutions) lead publicly traded companies to universally set a floating stock price and a fixed quantity of shares? Why not let the quantity float and the price stay fixed? If we were perfectly logical beasts, we should be indifferent between the two.

Saturday, October 24, 2015

The minsicule bid ask spreads we see in financial markets today indicate that stocks and bonds have never been more liquid. At the same time, skeptics worry that the odds of a sudden evaporation of this liquidity has never been higher. This Jekyll and Hyde world of ultra liquidity coupled with heightened risk of liquidity famines is one of the core themes running through a great series of posts on market liquidity from Liberty Street, the NY Fed's blog. See here, here, and here.

To protect their portfolios, investors need to be able to look beyond the incredible amounts of potentially superficial liquidity coursing through markets and plan for future illiquidity crisis. For this sort of preparation to be possible, what investors really need is a market in long-dated liquidity-related financial products.

Central banks have historically been the chief providers of liquidity-related financial products, namely liquidity insurance, or the guaranteed use of central bank lending facilities in a crisis. The problem, as Stephen Cecchetti and Kermit Schoenholtz point out, is that we simply don't know if central banks are offering this financial product at the right price and in appropriate quantities. Cecchetti & Schoenholtz say that providing lending facility access:

without limit and without penalty can lead to enormous moral hazard, causing overreliance on the central bank. If market participants are trained to ignore liquidity risk in good times, they will do little to make markets less fragile or to prepare themselves for unanticipated, but persistent episodes of market illiquidity.

The other problem is that central banks only provide liquidity insurance to banks. What about the rest of us? How can all investors, and not just bankers, benefit from properly priced liquidity insurance products?

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A central bank is a monopolist without much business sense. It has no idea how to set the proper price for insurance products. Which is why I think a private market in liquidity options, or liquidity insurance, may be an ideal solution.

How might these liquidity options look?

An option to sell at the ask price

In financial markets there is a price at which participants are willing to buy and a price at which they are willing to sell. This is the famous bid-ask spread, or bid-offer spread.

Say the bid, or buying price, for Google shares is $650 and the ask price is $660, the width of the spread being $10.

A seller with time on their hands will join the queue of sellers already at $660 and wait for a buyer to step forward. If the seller is desperate for liquidity, they will sell at $650 to the first buyer in the bid queue, absorbing the $10 loss. When a liquidity crisis hits, this spread may widen out such that a desperate seller will only be able to get out at $640, or $600.

Liquidity risk can be thought of as thusly: We'd all love to rapidly sell at the offer, or ask price, but reality forces us to trek the distance across the spread and sell at the bid. In normal times, who cares; the spread is miniscule. But this trek-to-the-bid gets much costlier in a crisis when spreads widen out.

A liquidity option would be designed to allow investors to do the impossible: sell rapidly at the offer price. Using the Google example from above, an investor who buys a Google liquidity option would be allowed to exercise the option and immediately buy Google from the option seller at the current market offer price, say $660, and not the bid price, say $650. If buyers were to flee and liquidity evaporate such that the level of bids falls to $600, the owner of the option is protected since they can sell Google at the offer price of $660, and not the much lower bid price of $600.

Think about it this way. Whereas a regular put option provides downside price protection by allowing the owner to sell at a fixed price, a liquidity option allows them to sell at a fixed spread. Buying liquidity protection for one Google share would probably be much cheaper than getting downside price protection for that same share.

What should the price of a liquidity option be? Say that the difference between Google's bid and ask is typically $10. An insurance writer who is is required to purchase Google from the option owner at the offer price can typically only offload this risk by turning around and selling Google at a $10 loss. They will therefore require an initial insurance payment, or premium, of at least $10 to compensate.

When a liquidity crisis hits the current bid-ask spread will widen and insurers will ask for higher premiums on newly issued insurance. If current liquidity stays healthy but the odds of future liquidity crisis increase such that future Google bid-ask spreads are expected to be quite wide, then the liquidity insurance writer will require more compensation as well. The value of a liquidity option depends on both current and expected illiquidity. Conversely, if liquidity risks are expected to decline, buyers will ask for lower premiums since they don't expect the insurance to offer much protection over its contract life.

Those investors who have hedged against liquidity risk by buying liquidity options need never fear illiquidity again. If liquidity stays healthy their liquidity options will expire worthless but they'll have no problems exiting their positions. If liquidity deteriorates they can no longer exit their positions directly by selling on the market but can just as easily get liquid by exercising their options.

In addition to Google, a well designed liquidity market would have liquidity options on all major equities, ETFs, and widely traded fixed income products. Full democratization of liquidity insurance would be achieved by having these options trade on public markets. Information about the price of liquidity would become widely available so that investors could "internalize liquidity risk", as Cecchetti & Schoenholtz put it. If they didn't like the risks they found themselves facing, investors could use these products to reorient themselves. Take a family with a mortgage that was too afraid to buy Google because of the potential for an outbreak of illiquidity at the same time that a mortgage payment comes due. The can now own shares and hedge away their liquidity risk by purchasing a liquidity option. Folks like Warren Buffett, a conservative investor with a strong balance sheet capable of withstanding liquidity crisis, would be able to earn extra income by writing liquidity options and collecting premia.

In sum, with a well designed liquidity options market, the risks of illiquidity are distributed to those who want to bear them and away from those who don't. Markets will probably be much less fragile. As for central banks, with the market providing both liquidity insurance and liquidity pricing, central bankers can focus much more on what they should be doing; monetary policy.

Wednesday, October 14, 2015

What makes ride sharing firm Uber interesting is not just its use of new technology to mobilize unused car space, but the method it uses to price its services. Uber's surge pricing algorithm varies cab fares dynamically. To get from A to B, the car that you hired this morning for $10 could end up costing $100 this afternoon.

How unlike the traditional taxi fare it is displacing! In their 2004 paper on sticky prices, economists Bils and Klenow found that taxi fares tended to remain at the same level for 19.7 months before being adjusted. Getting from A to B pretty much costs you the same price day-in-day-out for almost two years.

In our internet age, are prices getting less sticky?

At first glance no. Alberto Cavallo, who along with Roberto Rigobon created the Billion Prices Index (the bane of all inflationistas), has analyzed scraped data from the websites of retailers who continue to sell mostly through bricks & mortar stores, say like Walmart. Cavallo finds that U.S. online prices stay fixed for 42 days, about the same as offline prices.

On the other hand, Gorodnichenko, Sheremiro, and Talavera find that online prices exhibit more flexibility than offline prices. Unlike Cavallo, the authors analyze data from an online-only store, say like an Amazon (they aren't permitted to disclose which store). However, while Gorodnichenko et al find that online prices are less rigid than bricks & mortar prices, they still exhibit unusually long price spells, or periods of fixity. These spells tend to endure for about 7 to 20 weeks, two-thirds shorter than offline spells when the effect of discounts/sales has been removed. The result is counter-intuitive, say the authors, given that online stores have the technology to cheaply adjust prices as supply and demand change, yet for some reason choose not to.

Even though both papers were published in 2015, Cavallo and Gorodnichenko are using relatively stale data. The first dataset runs between October 2007 and August 2010 while the latter spans the period between May 2010 and February 2012. This delay is unfortunate as the online world is changing fast. Recent industry articles point to a large ramp-up in the use of dynamic pricing by retailers over the last few years. For instance, Profitero, a price intelligence provider, charts out a step-wise change in the pace of Amazon's price changes beginning in late 2012. According to competing price intelligence company 360pi, by 2014 some 18% of Amazon's prices were changing daily.

The same goes for an old dinosaur like Sears. While Sears' online prices rarely underwent changes in the earlier part of this decade, around 18% of its prices are now being adjusted each day, on par with Amazon. And now Sears is trying out digital signs in its bricks & mortar stores to ensure quicker offline price changes.

The moral economy

If we are indeed entering an Uber-style flex-price world, what underlying factors had to change for this to happen? It's not technology—we've always had the means to set rapidly changing prices, just look at financial markets. If anything had to bend in order for pricing patterns to change, it was the ethics of price setting.

To understand why, we need to explore one of the enduring questions in economics: why goods & services prices remain fixed in the face of continuously changing demand and supply conditions. When economist Alan Blinderpolled businesses in the early 1990s to find out why they kept prices unchanged for long periods of time, the most common answer was the desire to avoid "antagonizing" customers or "causing them difficulties." Blinder's findings evoked Arthur Okun's earlier (1981) explanation for sticky prices whereby business owners maintain an implicit contract, or invisible handshake, with customers. If buyers view a price increase as being unfair, they might take revenge on the retailer by looking for alternatives. A retailer who promises to adjust prices rarely and only when costs justify it thereby avoids antagonizing customer sensibilities, and in return the customer provides a degree of loyalty.

The idea that prices are set within an overall moral framework predates Blinder and Okun. Nobel Prize winning economist John Hicks, for instance, once wrote that the notion that all prices are perfectly flexible was highly unrealistic and attributed rigidity to legislative control, monopolistic action "of the sleepy sort which does not strain after every gnat of profit, but prefers a quiet life," and "lingering notions of a ‘just price’."

Hicks' use of the word 'lingering' refers to the extended lineage of the concept of the just price. The belief that it is in some way sinful to sell a product for more than its fair price is a very old one, going back to early economic thinkers like Thomas Aquinas. In the age that Aquinas inhabited the economic roles that individual were permitted to play and the prices they could set were determined by tradition and custom. Historian E.P Thompson once referred to this as the "moral economy." For example, medieval English farmers could not sell their corn directly from their fields but had to bring it in bulk to the local "pitching market." Speculation, or the practice of "withholding" in the anticipation of better prices, was prohibited. Once at market, no sales of corn could be made before stated times. When the bell rang, the poor had the first chance to buy, and only after could larger dealers make purchases. These various market structures were designed to ensure a just price and fair profits.

Even as these structures were slowly unwound, writes Thompson, the English populace clung to the old morality, the physical incarnation of this being food riots which swept the countryside during the 18th century. These riots weren't random attempts to pilfer. Rather, they were relatively sophisticated affairs whereby rioters would organize to set the price of a good, in effect forcing the offending retailer to sell their wares at the level deemed just rather than at its much higher market-determined rate.

In the same way that 17th century rioters self-regulated markets by threatening to set the price for corn or bread, modern shoppers who encounter an unjust price threaten to cross the aisles towards the competition. Eager to avoid being punished by their customers' wrath, retailers implicitly promise to keep their prices fixed for long periods of time.

I find it interesting that even when we start from scratch, the notion of a just price quickly emerges. In his account of a temporary P.O.W. camp economy in which cigarettes circulated as money, R.A. Radford notes that:

There was a strong feeling that everything had its "just price" in cigarettes. While the assessment of the just price, which incidentally varied between camps, was impossible of explanation, this price was nevertheless pretty closely known. It can best be defined as the price usually fetched by an article in good times when cigarettes were plentiful. The "just price" changed slowly; it was unaffected by short-term variations in supply, and while opinion might be resigned to departures from the "just price," a strong feeling of resentment persisted. A more satisfactory definition of the "just price" is impossible. Everyone knew what it was, though no one could explain why it should be so.

Behavioral economists also find evidence of a just price mentality. Using telephone surveys, Kahneman, Knetsch, and Thaler were able to isolate community standards of price fairness. Generally, consumers feel they are entitled to their reference price, or past price. They also believe firms are entitled to their reference profit and deem it fair for a firm to raise prices to protect that profit, say because the firm's costs have increased. A firm that takes advantage of an increase in demand by raising its price and makes more than its reference profit is, however, breaking the rules of the game and acting unfairly.

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So let's bring this back to Uber surge pricing and Amazon/Sears dynamic pricing.

I see two angles here. After centuries of a just price morality, perhaps we are inching towards an alternative framework. Maybe we've finally overcome our revulsion to an 'unfair price' that varies according to fluctuations in demand. Instead of the 19.7 month price spells of yore, we're now willing to endure 19.7 minute price spells. Morality changes, after all; slavery and death penalties used to be common, abortion was prohibited. If so, Uber and Amazon's pricing policy are emblematic of this underlying morality switch.

Or maybe we haven't switched at all and are still operating under the old rules of the moral economy. If so, the new pricing technologies adopted by Amazon and Uber are destined to be met by a titanic wave of consumer revulsion. This may be already happening; Uber's surge pricing policy has attracted plenty of negative press (here and here). Morality is a powerful force; unless they want to be dashed to pieces, the offenders will have to relent and make their prices more sticky.

Monday, October 5, 2015

Why can't we create inflation anymore? Maybe it's because money isn't what it used to be.

Money used to be like a car; the market expected it to depreciate every day. When we buy a new car we accept a falling resale value because a car provides a recurring flow of services over time; each day it gets us from point a to point b and back. And since these conveniences are large, the market prices cars such that they yield a steady string of capital losses.

Money, like cars, used to provide a significant flow of services over time. It was the liquidity instrument par excellence. If a problem popped up, we knew that money was the one item we could rapidly exchange to get whatever goods and services were necessary to cope. Given these characteristics, the market set a price for money such that it lost 2-3% every year. We accepted a sure capital loss because we enjoyed a compensating degree of comfort and relief from having some of the stuff in our wallets.

These flows of services are called a convenience yield. Assets that throw off a convenience yield, like cars and money, typically have negative expected price paths. Let's call them Type 1 assets.

Type 2 assets, things like stocks and bonds, don't boast a convenience yield. Without a convenience flow, people only buy them because they promise a real capital return. One way a Type 2 asset provides a capital return is via a positive expected price path. We only hold Google shares because we expect them to rise by around 5-10% a year. Same with treasury bills. The government issues a bill at, say, $97, and they mature a year later at $100.

Another way for a Type 2 asset to provide a capital return is via periodic payments. A bond or an MBS doesn't rise over time. Rather, it provides its return in the form of regular coupon payments.

Could it be that money has steadily lost its convenience yield? If so, it's shifted from being a Type 1 asset with a negative expected price path towards being a Type 2 asset. That would explain our new deflationary era. In the same way that Type 2 assets like Google and t-bills have to offer a positive expected price path if they are to be held, the purchasing power of money needs to improve over time. And since everything in the world is priced in terms of money, that means that the price level can no longer inflate, it has to deflate.

Where has money's once considerable convenience yield gone? The costs of creating liquidity have been steadily diminishing. Wall Street has been able to make a wide variety of assets like stocks and bonds much more liquid at less cost. So whereas money was once the liquidity instrument par excellence, people now have a multitude of liquid instruments that they can choose from. At the same time, central banks, via quantitative easing, have create massive amounts of central bank liabilities. With a sea of liquid assets, maybe liquidity just isn't a valuable commodity anymore.

Welcome to deflation, folks. Into the vacuum left by money's retreating convenience yield, a promise of capital returns has sprung up.

Reversing deflation?

Even if money has become a Type 2 asset, central bankers can still get the inflation rate back to 3%. To do so, they'd have to change the nature of the capital return that it offers. Like Google shares, money now seems to promise a rising expected price path (i.e. deflation). Central bankers need to switch that out with a bond-style promise of juicier periodic payments. This would involve a central banker ratcheting up the interest rate on money balances, or reserves, to an above-market level. Only with an unusually high interest rate on reserves would people once again accept a declining expected price path for money (i.e. inflation).

For an analogy, imagine that tomorrow the U.S. Treasury were to issue a new 10-year bond with an outlandishly high 10% coupon. With the market-clearing yield on existing 10-year bonds sitting at just 2%, the new bond would start trading at a large premium to its $1000 face value and slowly fall over time. Likewise, money that sports an outlandishly high interest rate would steadily lose purchasing power.

Ratcheting up rates in order to get us back to a 3% inflation path could be a ghastly experience. Before it can start rolling down the hill again, money's purchasing power would have to rise sharply in value. But money is the unit in which everything else is priced, which means the price level would need to rapidly deflate. If prices are sticky, this could result in a glut of unsold labour and goods; a recession.

Alternatively, might a central bank rekindle inflation by forcing interest rates below their market level? In the short term we'd get a quick one-time dose of inflation. But after the adjustments had been made the price level would only continue its previous deflationary descent. A central banker would have to consistently ratchet down interest rates to generate a perpetual series of one-time inflationary pops in order to keep hitting its 2-3% inflation target. This strategy would run into problems. Go much below -1% and a central bank will hit the lower bound. Unless it wants to risk mass cash storage, it won't be able to go further. Even if a central bank devises ways to get below -1%, it'll have to perpetually ratchet rates down in order to spur the next one-time pop in inflation. Once it hits -20%, or -30%, one wonders whether the market won't simply adopt an alternative currency.

Given that these two options don't seem too comforting, maybe we should just get used to a bit of deflation.